Should You Pay Down Your Debts or Invest? The Answer May Surprise You

Paying down debts versus investing does not have to be an all or nothing proposition.

It's easy to feel pelted by financial advice, to absorb so many contradictory messages that you're paralyzed by indecision. For example, you know you should pay down debt, and you're confident that investing is the best way to plan for the future, but which is more important?

The truth is, they should both be priorities. The trick is figuring out which financial move to tackle first. Here, we'll help you do that.

The rule of 6%

The rule of 6% says that if you have debt with an interest rate of 6% or more, you should focus on paying it off before turning your attention to investments.

The right percentage for you may be slightly lower or higher, but the principle is the same. Choose an interest rate and focus on paying off any debt that meets or exceeds that rate.

Here's why

Let's say you invest money in the S&P 500 index, which tracks the performance of 500 of the largest stocks traded on the Nasdaq and the New York Stock Exchange (NYSE). While there are never any guarantees when you invest in stocks, the S&P 500 has historically represented a solid investment.

For example, the S&P 500 has only delivered negative annual returns in five of the last 30 years. In 11 of those 30 years, it provided annual returns of more than 20%. On average, the S&P 500 has produced an annual return of nearly 10%. 

If the interest rate on your debt is 6% or less, chances are you'll come out ahead by focusing on investing first. After all, earning 10% on your investments beats saving less than 6% in interest payments.

Of course, if your debt carries an interest rate of 6% or more, it pays to focus on paying it down first. While investments have flourished more often than they've tanked, there are years when things go south, and even when the market provides a positive rate of return, it's not always 6%. 

For example, in 1994, the rate of return was 1.32%. In 2005, it hit 4.91%, and in 2015, the S&P 500 rate of return was 1.38%. 

Several assumptions

In coming up with its rule of 6%, Fidelity assumed three things. 

1. You have at least 10 years before you plan to retire.
2. You're investing in a balanced portfolio that includes about 50% in stock.
3. You're investing in a tax-advantaged account, such as a 401(k) or an IRA. 

What is a tax advantaged account?

When you invest money in a 401(k) or a traditional IRA, that money comes off the top of your earnings and is not taxed until you withdraw it during retirement. Many folks presume they'll have a lower income in retirement and therefore a lower tax rate. 

A balanced approach

The decision to pay down debt or invest is not necessarily an all-or-nothing proposition. For example, let's say you have a mortgage with an APR of 4.5%, an auto payment at 5%, and a credit card at 17% interest. You can focus on paying down the credit card only while also seeing to other financial matters. For example:

• Continue to make the full payment on your mortgage and auto loans.
• Carve out a little money each month to tuck away in an emergency savings account. Having an emergency fund may save you from pulling out a credit card to cover emergency expenses. 
• If your employer matches any portion of your retirement contributions, take advantage of the free money. For example, if your employer matches 3%, make sure you're putting a minimum of 3% into that tax-advantaged account. That way, you're putting 6% away for retirement each month. 

Ask anyone how much they enjoyed the process of paying off high-interest debt and you're likely to receive a funny look. While paying off debt may not be anyone's idea of a good time, it's the fastest way to position yourself with more money to secure your future.